Fixed income
24 Mar 2020 | By Huw Davies

A contingency plan

The Merian Financials Contingent Capital Fund’s preference for well-capitalised, high-reset CoCo bonds has meant that it hasn’t been as exposed to the negative convexity attributes of lower-reset bonds, many which are now trading as perpetuals given the widening in spreads. The Fund’s lack of lower quality names has also helped performance to some degree, although not as much as would have been expected.

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Volatility across all asset classes has spiked higher, and the CoCo market has been no exception to the rule; however, the volatility of the Fund and its CoCos index – the Bloomberg Barclays Contingent Capital Western Europe TR Index – remain very similar and are still less than half that of the Euro Stoxx Bank Index.

 

Liquidity punished, for now…

One of the major issues of markets over this volatile period has been liquidity. We have always highlighted the liquidity of the CoCo market  as a major positive for the asset class and in this most highly stressed of situations it has very much proved to be the case. Anecdotally, numerous traders have told us that they have been trading hundreds of millions of US dollars of CoCos in recent days. This is in stark contrast to high-yield bonds, where the market is completely bid-less and very little is trading. However, this characteristic does have a downside for CoCos. Investors have been scrambling to raise cash in recent days; and in an illiquid marketplace, selling becomes centred upon the more liquid parts of the market. Government bonds, gold, silver and CoCos have been the victims of this move. This phenomenon is known as negative selection bias and it has never been clearer than over the recent days. Dealers are refusing to put a firm bid on a range of sterling AAA covered bonds, but are willing to bid on CoCos.

We have been able to buy high yield bonds 10-12 points below the supposed screen price, meaning high yield is trading 100s of basis points wider of the screen price. The valuation of where the high yield market has traded is an inaccurate picture, in our opinion: how do you know where an asset class is being priced if it isn’t trading? If you are a forced seller of high yield, the price is significantly below where the screen indicates.

This liquidity has also led to indiscriminate selling in CoCos as investors focus on raising cash; the fund has suffered as a result, with indiscriminate selling across the quality spectrum, disproportionately hitting those higher quality bonds.

 

Quality will shine through

We believe this is an enormous buying opportunity. Unlike many of its peers, the Fund has not suffered outflows, so high-quality positions have not had to be reduced. We are happy with the quality and structure of the portfolio and don’t believe that the authorities will allow banks to fail because of Covid-19. 

The desire of investors to hold cash points to an underlying acceptance that this is not a systemic issue for the global financial system. At the time of the global financial crisis everyone wanted government debt, not cash, because trust in the international banking system had collapsed; the fact that right now cash is seen as the preferred asset to many other asset classes shows that there is not an underlying confidence issue in the banking sector.   

This view is reflected in research notes we’ve seen from various investment banks. The following is a precis of a note this morning from Citi. On the back of a number of client questions surrounding CoCo coupon passes, Citi has been expressing the view that the chances of CoCos seeing coupon skips are relatively low, particularly amongst the larger well-capitalised banks. The current situation is an economic/macro repricing of risk generally, rather than a breakdown of the market structure for CoCos. In contrast to the 2008/2009 situation, the banking sector is not the root of the problem but rather part of the general solution to supporting the wider economy and loosening credit conditions. The authorities’ support for the system is similar to the financial crisis, and, given the healthier starting point for the banking sector, this means that the risk of a systematic banking crisis is low. The regulatory easing we have seen has been large and is to allow banks to have sufficient capital to lend, but it has also increased the headroom to the maximum distributable amount, with the average benefit seeing that headroom increase by around 60bps, and for some up to 250bps (ABN). The expectation is that all large banks will do everything they can to avoid a coupon pass on CoCos.

In the circumstances, the CoCo market has performed well relative to other asset classes from a pure performance and liquidity standpoint. The liquidity of the market has been impressive and is something we believe has been massively undervalued by the market. In a post Covid-19 world, the premium for liquidity will be much higher; in this phase it has acted against CoCos in the form of a negative selection bias, but we don’t believe that will be the case in the future.

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